With the incredible returns we’ve seen over the last 18 months it’s easy to ignore stock valuations. Big gains and new index highs inspire confidence that everything is fine, otherwise stock prices wouldn’t be going up so fast. At times, riding the market tailwinds can be an exceptionally profitable investment strategy. So why bother to look at valuation? It hasn’t mattered for years.
One way to think about valuation is that it puts a number on investor expectations. High valuations imply high expectations. If a company is trading above 10x price/sales, expectations for future revenue growth are high. As long as the company delivers on these expectations, and future growth prospects remain vast, the shares can climb higher. But fast revenue growth can’t continue forever – a market segment approaches maturity, competitors emerge, the concept loses appeal – and high expectations lead to disappointment. Few traits are more damaging to a high-expectations stock than disappointment. Look no further than former darlings with dashed growth expectations like Peloton (PTON), down nearly 80% from its peak, Moderna (MRNA), down 40% and QuantumScape (QS), down 80%.
In late August, the total market value of companies with valuations over 10x sales was $14 trillion. Not only is this nearly triple the prior tech cycle peak in 2000, it is seven times higher than only three years ago. Clearly, enthusiastic investors have rosy expectations about the future. One may ask if mega-cap tech stocks like Apple (AAPL), Meta Platforms/Facebook (FB), Alphabet (GOOG) and Amazon (AMZN) bias this data? They do not, as they each have price/sales multiples below 10x.
What should a savvy investor buy at this stage of the cycle – especially as the tailwinds from copious amounts of fiscal and monetary stimulus are fading or possibly reversing?
Consider “Low-Expectation” Stocks
One sensible approach is to begin trimming out of high-expectations stocks while adding to low-expectations stocks. One such stock is Bristol-Myers Squibb (BMY)1. Investors worry about Bristol’s long-term revenue growth, as key products Revlimid, Opdivo and Eliquis have patent expirations over the next several years. But the company is likely to replace the lost revenues with its robust pipeline and sensible acquisitions. The likely worst-case scenario is flat revenues.
Near-term prospects remain healthy: consensus Wall Street estimates project that Bristol will produce 2-3% revenue growth over the next few years following robust 9% growth in 2021.
Investors, however, have low expectations that even this modest scenario will play out. BMY shares trade at only 7.6x estimated 2022 earnings and 7.3x estimated EV/EBITDA. Yet, the company will likely generate $15 billion of free cash flow in each of the next three years – this is the equivalent of 36% of Bristol’s market cap. The investment grade balance sheet carries modest leverage, with its $15 billion in cash offsetting much of its $44 billion in debt (net debt is only 1.3x EBITDA). And the management is shareholder friendly, recently raising the dividend by 10% (producing a dividend yield of 3.5%) and authorizing a new $15 billion share repurchase program.
Shares of Bristol-Myers already assume a disappointing future. It won’t take much good news to beat these low expectations and lift Bristol-Myers Squibb stock.
- Disclosure Note: The author of this article personally owns shares of Bristol-Myers Squibb (BMY).
Do you own any stocks that you would consider “low expectation”?